was the reason that a safe withdrawal rate needs to be established in the first place — it is the first line of defense against sequence-of-returns risk .
And that risk , sources say , looms large .
Predicting Sequence-of-Returns Risk
This is the phenomenon that occurs when a retiree ’ s portfolio is subjected to low returns early in the drawdown period and for long enough that it never recovers , potentially leaving the retiree years short on assets .
Kitces says one thing advisors often get wrong about sequence risk is that the risk doesn ’ t lie in just a couple of bad years of returns right when a client retires . “ Sequence-of-returns risk , it turns out , is mostly about what happens in the first decade after retirement , magnified ,” he explains , adding that while clients should fear a market crash early in retirement they also should fear volatility and a slow recovery or an extended period of low returns . “ If the first decade is really bad , if you ’ re not doing something to defend against that bad decade , whatever assets you have slowly run out and you eventually have a problem ,” he says .
Between 2009 and 2020 , advisors didn ’ t have to worry about this particular risk , though they didn ’ t know it at the time . Longevity risk was far and away a more common topic of conference sessions during the extended bull market .
But the current economic and market environment is more uncertain , and industry experts , regardless of what they espouse to be a safe withdrawal rate , have been agreeing that there are more signs out there that the American retiree is more vulnerable today to sequence risk than in the recent past . While there are no ironclad predictors that a new class of retiree will be dealing with the pain of sequence risk , there is agreement that high P / E ratios are a leading indicator that the risk is high , and in particular the cyclically-adjusted ratio developed by Nobel laureate Robert Shiller of Yale University in 1996 , known as the Shiller P / E ratio .
Shiller ’ s ratio is considered by some experts to be a better market valuation measure than the P / E ratio investors use because it strips out fluctuations due to the variation of profit margins during business cycles . “ The P / E measures that are often used in investment markets for investment decisions may be fine for investment decisions , but it turns out they ’ re not nearly as predictive of retirement sustainable spending ,” Kitces explains .
In particular , he uses a 10-year average of the Shiller P / E ratio to create a snapshot of the current level of likelihood for sequence risk . And that ’ s about it .
When sequence-ofreturns risk is accounted for , Kitces says today is a much worse time to retire than 10 years ago .
“ There have been a couple of studies over the years that have tried to draw a link to interest rates being an additional factor , but most of them either have not been terribly conclusive or haven ’ t really shown more predictive value than market valuations ,” he says . “ Sequence risk comes from stocks simply because they are the things that are volatile and could have such long-term periods of potential underperformance .”
The upshot is that today is a much worse time to retire than it was 10 years ago when you take into account sequence-of-returns risk , he says . “ That ’ s what the data would tell you .”
Mitigating Risk With Rightsized Spending
Although technically the 4 % rule is robust enough to get retirees through the likes of the Great Depression and the high-inflation 1970s , augmenting this approach with “ guardrails ” can provide the same downside protection while actually increasing what retirees can spend in retirement .
And this is one area where Kitces and Rekenthaler agree right off the bat . In fact , Morningstar ’ s latest safe withdrawal report dedicated nine pages to research looking at how an effective guardrails system — where retirees get a raise when the markets do well but rein in their spending when the markets don ’ t — can support higher safe withdrawal rates at the beginning of retirement , result in higher lifetime withdrawal rates , and still leave some assets for the bequests .
“ The best approach would be to split up the portfolio , get some part of it devoted to guaranteed income , and then be flexible with the remaining portion ,” Rekenthaler says . “ The way to get higher withdrawal rates over time during retirement is to be flexible and to respond to market movements .”
That flexibility would start , according to Morningstar , with a safe withdrawal rate of 5.2 % that gets adjusted annually according to portfolio performance and the previous withdrawal percentage . If the market is trending upward and all criteria are met , the retiree would get a 10 % increase on top of the inflation-adjusted prior-year withdrawal .
But if the market is dropping and the reverse happens , the retiree would cut the annual withdrawal by 10 %. “ I ’ m a fan of the guardrails kind of approach ,” Kitces agrees . “ Looking at this in practice with retirees over the years , I see that people can make some adjustments . We don ’ t like making big adjustments , and we don ’ t like making a lot of adjustments . But if I spend less in down markets , it turns out that helps my sequence-of-returns risk . Because I ’ m spending less when the markets are down , that helps to smooth the path .”
Plus , this approach takes human behavior into consideration : When the headlines scream “ financial crisis ,” people tend to respond by slowing their spending .
“ Guardrails just acknowledge the reality of what we already do ,” Kitces says . “ But it turns out , if you actually consider that in your planning , it does let you spend a little bit more up front if you ’ re willing to make some adjustments as you go .”
DECEMBER 2023 | FINANCIAL ADVISOR MAGAZINE | 55